Gold standard test looms as Greek debt worries swirl at IMF meeting

Eighty years ago, Britain left the gold standard. It reminds you of some of the things going on today.

Read the front page of the Financial Times of 21 September 1931, for instance, a day after the move. “The step now taken is due solely to heavy withdrawals of sterling by foreigners. Their exaggerated fears have brought about the new situation.”

Well that’s all right then. Elsewhere, one reads: “Temporary step only….There is in no sense a crisis. Internally the affairs of the country will proceed along normal lines.”

In fact, Britain’s relinquishment of the gold peg, while giving much-needed stimulus to the domestic economy, piled up pressure on the main gold-adhering countries of the Continent, Germany and France, to follow suit. Nowadays we’d call it “contagion risk”. Germany stood firm. France didn’t, eventually departing the gold standard in 1936 in a hotly-contested move by the Popular Front government of Léon Blum. The rest is, mainly unpleasant, history.

Scroll forward to the present, and you see some dark similarities in today’s dilemmas for European governments.

These reflections seem particularly apt at the annual meetings of the World Bank and International Monetary Fund in Washington, where I have been in the last few days. The European debt crisis has overshadowed the gathering like no other matter. Broadly speaking, the world is curiously divided over the Greek debt issue between the creditor and debtor nations. The first group, led by the Germans and Chinese, regard the idea of the Greeks not repaying their debts in full (or even leaving monetary union) as preferable to throwing ever more taxpayers’ money at an unending problem. The debtors, with the Americans in full cry, are calling loudly for more aggressive European action, including extra borrowing by the EFSF rescue fund, to avert what George Soros, the veteran fund manager, called in Washington “the breakdown of the global financial system as we know it”. Gao Xiqing, president of China’s sovereign fund, China Investment Corporation, took a less frenetic line, saying sagely, “Just because people say it’s going to be the end of the world doesn’t mean it’s going to happen.”

Meanwhile Evaneglos Venizelos, the robustly impressive Greek finance minister, warned bankers that, although Greece had made the “final and irrevocable decision” to remain in the euro, it refused to be made a “scapegoat” for problems in economic and monetary union (EMU) caused by other countries.

Venizelos darkly reminded his audience that he was a former defence minister. Indeed, shortly before EMU started in 1999, then German Chancellor Helmut Kohl said the single currency was a question of war and peace. Yet even Kohl did not foresee that EMU, the proudest yet most vulnerable of Europe’s accomplishments, would degenerate into an issue of political life or death for his successor at the helm of the conservative Christian Democrat party, Chancellor Angela Merkel.

In a currency system riven by fractiousness between debtors and creditors, Merkel is the one European political figure who can determine the fate of the 17-member single currency. Her one-time economic adviser and now the new Bundesbank president Jens Weidmann, has said publicly EMU has to go in one of two directions. Either it takes the path of a fiscal union in which member countries fuse together their economic and financial systems into a much more robust framework that will protect them from internal dislocation. Or EMU remains a looser grouping of countries that will face the discipline of the financial markets if they fail to produce economic convergence. This could lead to harsh consequences in cases where states fall out of kilter with stronger-performing economies.

The logical extension of Weidmann’s thoughts is that countries which do not make the grade might default on their debts and/or leave the euro. The warnings are underlined by the downward spiral of the Greek economy.

Merkel reasons that the costs of a Greek debt restructuring, especially in view of a possible extension of attrition to Spain and Italy, would far outweigh the gains.

The difficulty is that she is beset by constraints that could sweep away her hold on power. Merkel is hemmed in by the Bundesbank’s continued drumbeat of opposition to European Central Bank support purchases of errant countries’ bonds – and nagging doubts that the support may be illegal.

A crucial landmark this coming Thursday will be a German parliamentary decision on expanding the EMU rescue fund, the European Financial Stability Facility (EFSF) which was conceived in May 2010 and is meant to be extended in scope and scale under a European decision in July 2011. A parliamentary majority is assured, but Merkel may have to rely on support from the Opposition Social Democrats and Greens. This would grant temporary respite for EMU, but it could bring forward German elections scheduled for 2013, and hasten the Merkel government’s replacement by a “Red-Green” coalition.

Which brings us back to the gold standard. Back in 1931, the conservative Reichsbank, the forerunner of the Bundesbank, fiercely opposed Britain’s departure on the grounds of contagion risk – forebodings that proved accurate. His eight-decades-removed successor Jens Weidmann appears to be taking a more flexible line that doesn’t rule out that the occasional EMU member may end up leaving.

Politically, it will be extremely tight for Merkel, given her stated wish to preserve the EMU status quo. The tussle between the Chancellor and her one-time lieutenant Weidmann has some way still to run. A succession of German chancellors has seen their political careers ended over discord with the Bundesbank. Even though the Bundesbank has now been subsumed within the ECB, it still holds significant sway within German politics. Merkel could become the latest head to topple.